Chapter 10 Reporting and Analyzing Long Term Liabilities Basics of Bonds issuances Projects that demand large amounts of money often are funded from bond Bond is its issuer s written promise to pay an amount identified as the par value of the bond with interest Par value of a bond face amount face value is paid at a specified future date known as the bond s maturity date Most bonds require the issuer to make semiannual interest payments Advantages of bonds o Bonds do not affect owner control o Interest on bonds is tax deductible o Bonds can increase return on equity Financial leverage trading on the equity a company that earns a higher return with borrowed funds than it pays in interest on those funds causes an increase in its return on equity Disadvantages of bonds o Bonds can decrease return on equity when a company earns a lower return with the borrowed funds than it pays in interest o Bonds require payment of both periodic interest and the par value at maturity Bonds are securities that can be readily bought and sold A bond issue consists of a number of bonds usually in denominations of 1000 or 5000 and is sold to many different lenders Since bonds are exchanged bought and sold in the market they have a market value price Authorization of bond issuances includes the number of bonds authorized their par value and the contract interest rate Bond indenture legal contract between issuer and bondholders Bond certificate evidence of a company s debit includes issuer s name par value contract interest rate maturity date Bond Issuances Issuing bonds at par o Jan 1 2011 800 000 at 9 20 year bond that matures on Dec 31 o On jan 1st debit cash 800 000 credit bonds payable 800 000 o First semi annual interest payment on June 30 debit bond interest expense 36 000 credit cash 36 000 o Bond matures Dec 31 debit bonds payable 800 000 credit cash 2030 800 000 Bond Discount Premium o The contract rate sets the amount of interest the issuer pays in cash which not necessarily the bond interest expense actually incurred by the issuer o Bond interest expense depends on the bond s market value at issuance which is determined by market expectations of the risk of lending to the issuer o Market rate is the rate that borrowers are willing to pay and lenders are willing to accept for a particular bond and its risk level As the risk level increases the rate increases Market rate is generally higher when the time period until the bond matures is longer Many bond issuers try to set a contract rate of interest equal to the market rate they expect as of the bond issuance date When contract rate and market rate are equal the bond sells at par value Premium above par value Discount below par value Issuing Bonds at a Discount o Discount on bonds payable occurs when a company issues bonds with a contract rate less than the market value issue price is less than par value o Issuer must pay 2 separate types of future cash flows Par value at end of the bond s useful life Cash interest payments at the end of each semiannual period during the bonds useful life o Debit cash o Debit discount on bonds payable o Credit bonds payable o Carrying book value of bonds par value of bonds discount o Discount on bonds payable contra liability account o Compute bond interest expense Amount repaid to bondholders interest payments par value at maturity minus amount borrowed from bondholders o Amortize a bond discount o Straight line bond amortization allocates an equal portion of the total bond interest expense to each interest period total bond interest expense number of semiannual periods in the bonds life o Debit bond interest expense o Credit discount on bonds payable discount periods o Credit cash par value contract rate o Carrying value par value less unamortized discount o Unamortized discount decreases while carrying value increases Issuing Bonds at a Premium o When the contract rate of bonds is higher than the market rate the bonds sell at a price higher than par value o Premium on bonds the amount by which the bond price exceeds par value o Debit cash o Debit premium on bonds payable o Credit bonds payable o Same way as issuing bonds at discount to compute bond interest o Unamortized premium on bonds payable decreases and carrying expense value decreases Bond Pricing o Bond price quote o Current market yield rate o How to compute the price of a bond Present value concepts o Present value of a discount bond premium bond Compute the present value of a bond s cash payments discounted at the bonds market rate Use present value table to find present value factor multiple present value factor by cash flow payments add all up Bond Retirement Bond retirement at maturity o Carrying value of bonds at maturity always equals par value o Debit bonds payable o Credit cash Bond retirement before maturity o If interest rates decline greatly an issuer may wish to replace high interest paying bonds with new low interest bonds o Exercise a call option reserve the right to retire the bond early Call the bonds before they mature by paying their par value plus a call premium to bondholders o Purchase them on the open market o Debit bond payable Debit premium on bonds payable Credit gain can be loss on bond retirement Credit cash Bond retirement by conversion o Convert bonds to stock o Bonds carrying value is transferred to equity accounts no gain loss is recorded o Debit bonds payable o Credit common stock paid in capital in excess of par value Long Term Notes Payable Notes are issued to obtain assets Notes are transacted with a single lender such as a bank Installment note is an obligation requiring a series of payments to the lender franchise o Debit cash o Credit notes payable o Payments usually include the accrued interest expense plus a portion o Decreasing accrued interest increasing principle component equal of the amount borrowed total payments o Each period debit interest expense debit notes payable credit cash Mortgage is a legal agreement that helps protect a lender if a borrower fails to make required payments on notes or bonds o Mortgage notes carry a mortgage contract pledging title to specific assets as security for the note o Mortgage bonds are backed by the issuer s assets Appendix B Effective Interest Amortization Straight line method yields changes in the bonds carrying value bond interest expense remains constant gives the impression of a changing interest rate therefore we only allow straight line method when its results
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